Country Risk

China

China is ranked amongst the top countries which attract the most foreign direct investments in the world each year. The country has since maintained this fete as the top destination for foreign direct investments, even though it suffered a slight slump in the number of inward investment projects in 2006. This long-standing position has made it a choice for one out of every five investments announcements in the whole world since 2004.

In the recent past, the country has staged a lot of political and economic reforms in an attempt to attract and keep foreign investors. Some of the reforms include the steady increase in industrialization, the development of stock market capitalization, and market liberalization. These efforts have greatly attracted investors making the country unchallenged in its appeal to foreign direct investments. Foreign direct investment in China (FDI) is ranked as one of the world’s top destination with over US$ 560 billion being channeled into the country in 2004. The Ministry of Commerce estimated the figure at a slight drop to US$ 60.3 billion in 2005 excluding the financial sector. Although, the figure further dropped to US$32.7billion in July 2006, the country’s industrial sector continues to absorb over 70 percent of the foreign direct investments, especially the manufacturing industry. The volume of imports of foreign-funded companies have in the recent years accounted for 60 percent of the country’s income from total trade volume, (China Stock Market Handbook Editorial Board, 2008).

Microeconomic Environment

China had been having an exchange rate system which was pegged on the US dollar for over ten years. In this system, the Chinese Yuan used to be under the control of government which maintained it in terms of its variability leading to a market where the forces of demand and supply had no significant impact. The overall effect was the misalignment of the renminbi which has attracted calls internationally and locally for China to evaluate its exchange rate system.

The economy in China has been undergoing a transition which has seen it achieve stability in its macroeconomic and financial factors. In 2005, China revalued its exchange rate policy and instituted a reform which saw the former system replaced by a new system which allows the local currency to fluctuate against a set of currencies in order to boost the flexibility of the Yuan. This regime is based on market forces meaning it is free to move in the direction of the demand and supply in the market though it is monitored by the government to correct extremes.

The current regime has helped China achieve some of its goals relating to the balance of payments. For instance, it solved the problem of unstable exchange rates in line with the government’s push for more foreign investment through stable exchange rates as well as a market with no inhibition from speculative activities. It also boosted the development of the banking industry in addition to encouraging the growth and development of China’s export sector, (Ma, 2004).

Although, the government has slowed it’s spending in infrastructure development and instituted a relatively strict monetary policy, China still boasts of a sound economy which is currently transitioning as investors are now looking at new reasons for investing in the country due to its large domestic consumption being the major driver in the development of the economy. Over the last decade, the country has enjoyed a spectacular economic development driven by the increasing commodity prices and affordable foreign credit catapulting the country into a very appealing economy for investors. Local retail sales have been estimated to rise at 14.2 percent in September in comparison with 13.2 percent the previous month in 2012. China’s GDP in 2012 was estimated to be 50 trillion Yuan (5 trillion pounds), a figure that preceded a growth rate of 9.2 percent in 2011. This shows that the economy is quite strong and therefore could produce returns on investment. Even if it were to decrease by an annual rate of 7.5 percent, it could still support an increase of over 4 trillion GDP growths yearly. Currently, the country is predicted to develop in GDP by a rate of 8.4 percent in 2013 signifying its attractiveness for investment for both local and international entrepreneurs. In China, all companies, local or foreign-owned, are taxed alike. The country has also intensified efforts to make the tax systems clearer and simpler by eliminating contradictions and ambiguities in laws that govern taxation to favor taxpayers so as to orient it to investors who will be encouraged to invest since these efforts lead to low tax disputes between the authorities and the investor. Although foreign companies may enjoy certain regional incentives and grants that aim at attracting investment in priority industries, they are not given special treatment on taxation. It is very easy to enter China markets since for firms from the region, such as Korea and Japan, since the states come from the same region which shares a lot of common aspects of life such as language, cultures as well as common legal history and have same structure in business institutions and practices.

Indicators of the Overall Health of the Economy of China

Gross domestic product growth rate

The country has expanded by 7.7 percent in the first three months of 2013 more than the same period in 2012. It is expected to continue rising at an estimated rate of 8.4 percent annually.

Volume of imports

The country’s imports recorded an increase of 18,270,000,000 USD by March 2013 up from 124,118,000,000 USD in February 2013.

Volume of exports

The country’s exports increased from 139369,000,000 USD in February 2013 to 182,190,000,000 USD in March 2013.

Balance of payments

There was a deficit in the balance of trade in the country of 884,000,000 USD in March 2013.

The countries inflation rate

Inflation in March 2013 was recorded to be at 2.1 percent.

Political/country Risk

The political environment in the China is stabile and has a good network of infrastructure. It however shares the rising threat posed by terrorist incidents in the world. There have been bombings in some of the cities, though not by foreigners but the country’s residents. Terrorism continues to affect business in China though the government continues to put measures in place to curb the menace. These incidents have tainted the investment environment in the country, though not significantly, (Lee, 2013).

In addition to terrorist attacks, the harassment techniques and violent tactics used by protester during riots and strikes have resulted in a lot of business disruptions although the overall situation has started to improve slowly a result of government action. There have been developments in the country’s legislation to equip police with legal support to handle protesters; and the courts have continually used their powers in drawing a line between what is lawful harassment and protest and what is not. The government has also put measures in place to combat business crimes as well as reduce corruption by enforcing legislative measures in the economy. For instance, it is stipulated in the country’s constitution that bribery of any official is an offense punishable by the law.

China has been on a reform agenda to eradicate political impediments to investment. There has been a lot of emphasis in the degree of local autonomy on investment forms by the central government as well as the degree to which the local administrative institutions impact on entrepreneurial spirit in the country, (Su, 2003).

The level of regulation in the country has been seen as favoring foreign investors since the Government has developed and enforced rules and policies that support state entities while compromising on the privately owned organizations, a fact that discourages local investment and boosts foreign investments. The regulatory environment in China has reduced the amount of time and money employees and managers spend in complying with rules and regulations. Investors can now start businesses at lower start-up costs with less legal and compliance items than is the case in other overseas countries. This makes China a more conducive environment for investment dotted with attractive industries that hold the potential to supply cheap raw materials such as labor as well as demand for the goods and services investors will be engaged in.

The country has a mandatory regulation on all foreign investors that require them to jointly venture in their investments in the country. A partnership is required between the foreign investor and a local investor such as a government agency or local company. The judiciary has over the years made efforts to remain unbiased to local investors in terms of developing regulations for a legal, fair and ethical business environment. The Government has been instrumental in offering incentives that have promoted investment activities in the country. Some of these incentives have been in the form of introduced tax breaks, grants to foreign investors, government loans that draw low interest rates and increase in subsidies to international investors. Investor’s confidence is boosted by these activities since the potential of high business returns are increased within a short period of time.

Another challenge facing China is the earthquakes and tsunamis that have in the past rocked the country. Like most of the countries in Asia, China has suffered massive the loss of lives due to earthquakes and extensive destruction of infrastructure that include the transport system and buildings which form a core part in doing business. Every calamity that occurs in the country inhibits the development of the economy since the government has to use a lot of funds to reconstruct the destroyed structures before resuming business. Investment and saving activities are disrupted since people spend most of their income to restore themselves to normal while the government must shift from its economic activities and prioritize in delivering emergency rescue to the affected areas as well offer assistance that will set them on course for normal life.

Corporate Governance and Stock Market Conditions

Improvements in the general economy have been the major driver in foreign investments in China coupled with the opening up of new sectors for overseas investors as well as interested companies. This has become the country’s priority to shift from general investments in the economy to new areas which promise more revenue for the country.

Due to its improved financial markets, China’s security markets are very secure and liquid making them the most suitable for investors who would like to venture in other markets other than those in the U.S. In addition, the China boasts of most of the biggest blue chip organizations in the world thus giving investors an opportunity to hold blue chip stocks which are less risky. However, as much as it is more stable to invest in and the Chinese economy which consists 70 percent services, just like in most developed countries; it can lead to problems where such factors as commodity prices and consumer credit keep on changing (Xu, 2011).

China has a highly regulated financial system and has recently directed more focus on economic policy by steadily expanding its monetary policy. This has led to banks becoming important drivers in the country’s economy by prioritizing there lending to investors while seeking deposits from the public to reduce the liquidity in the economy as well as acting as government lenders. The country plans to do away with loan quotas and limit them for all lenders in line with the US$586 billion economic stimulus package of November 2008 and increase their bank credit to selected projects that include rural areas, macro-enterprises, companies dealing with technological products and services, iron and cement companies, (Hird, 1994).

Over a quarter of China’s markets are driven by investors of local origin. This makes policy pronouncements and speculation a very powerful factor in moving markets in the country. The country’s economy is mainly dominated by state-owned institutions and its blogosphere is very volatile to rumors. This is very different as compared to other developed countries such as the U.S where there are more institutional investors. Whenever there has been a rumor on a certain policy that could affect the life of the people or the way they do business, it spreads wildly changing the people’s reactions to investments and savings immediately, (Su, 2003).

In most companies, the board of directors is the one vested with the authority and responsibility to govern the affairs of the company. Shareholders elect the directors together with company auditors who they believe are capable to effectively run the company and satisfy their interests in it. In the UK and US, corporate governance is strongly influenced by the capital market. Companies are motivated to perform in line with measures in the capital market. It is thus such indicators as share prices that are used as benchmarks in measuring corporate performance. Managers of organizations are usually threatened by takeovers in order to work hard by taking appropriate actions to bring effectiveness in the companies which will restore its performance in the capital markets. Buy-outs have been used frequently in the UK for companies undergoing a downfall. Shareholders and other stakeholders who hold interests in particular corporations monitor their performance in terms of its returns and market share. Board of directors’ role is to basically monitor the activities of the corporation and to guarantee that managers perform in their activities so that the shareholders’ interests are maximized. In US, some corporations have a non-executive body of directors who oversea the daily activities of the company which have a long term bearing on its future. Some corporations also have an executive remuneration package which is basically an incentive for effective performance for managers (Xu, 2011).

In contrast, Chinese corporations focus more on stakeholders in the company rather than shareholders. Performance is likely to be measured in terms of how well the company has protected the interests of the stakeholders and not indicators such as maximizing shareholders’ wealth and company market share. The interests of stakeholders come first and are highly regarded than those of shareholders. Remuneration is more on the lower level of the executive than in US and UK corporations. Share cross-holding, a certain level of control by the People’s Bank of China, concentrated ownership and management, dormant market control for corporations and a significant credit control are some of the characteristics that mark corporate governance in China. The government, through the Ministry of Finance has a powerful hand in influencing corporate governance in China. Through the use of legislation and other mechanisms such as taxation, the government has an upper hand in determining the way companies operating in the country are run. This is because it wants to achieve certain goals and objectives such as a certain level of employment, selected industry development, investment in certain infrastructure projects as well as the growth and development in the general economy. Most boards consist of far too many and ineffective members despite the companies possessing very effective mechanisms internally that drive their existence. The country lacks an external market for controlling corporations and remunerations in the corporations are based on seniority. Senior executives are more compensated than their junior counterparts. In China, the number of shares one can hold is restricted by the constitution of the country, the ownership of the corporations is concentrated and the monitoring of these corporations is ineffective since there are no mechanisms in place to ensure adequate regulations in the activities of the company. Most corporations have in place supervisor boards that are incompetent perhaps because they elected to power because they are the pioneers of such organizations. The board is usually independent because it has no intervention from other stakeholders in the company due to lack of policies to bring it under pressure from such other bodies (Su, 2003).

As regards to markets risks, the country has inadequate instruments for diversifying risks especially hedging instruments. Most investment opportunities carry risks which unfortunately can not be adequately taken care off since China does not have a well organized financial system. Most of the local banks deal with savings and investments involving local transactions. They lack the capacity to adequately serve the international markets, a situation that denies the international investors vital instruments for the diversification of risks. The market in the country has inadequate issuers and securities. This is due to the small size of the markets. There is a challenge when it comes to the right methods and figures to use in comparing and gauging companies that are operating in China since the methods and procedures of recording and presenting data differs greatly with those of countries like the US. This often leads to the presentation of the wrong information regarding the healthy or strength of the companies.

Foreign investors face a number of risks in their relationship with the government of China. Sometimes investors’ assets might be expropriated or subjected to confiscatory taxes whenever company policies come into conflict with those of the government. In other cases, the value of the investor’s company might be adversely affected when diplomatic relationships change. Revenues from foreign companies might be blocked from expatriation or taxed heavily if the government intends to achieve certain economic goals such as discouraging investment in a certain sector to foster and nurture the local or private companies (Ma, 2004).

Generally, the political, administrative and legislative environment in China is a little inhibitive to foreign investments. China lacks adequate legislation in the corporate sector and the existing laws are poorly enforced. This gives room to such practices as corruption and misappropriation of funds in most businesses to thrive leading to a slow process of business and the general progress. There is a huge problem in the standards used for accounting and auditing. These procedures are poorly done since there are no clear standard guidelines that match the required international standards (Su, 2003).